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Published: November 30, 2009
It's a terrible time to be an income
investor...
The Fed has pushed interest rates to the lowest levels in
history. Money market funds pay nothing. Your bank account pays
nothing. Treasury bills pay nothing. Even if you decide to take
more risk and buy a long-term Treasury, you'll still make less
than 4%.
Municipal bonds are trading close to 40-year lows. The dividend
yield on stocks is terrible... at 2.2% for the S&P 500. Even my
favorite pipeline investments now yield less than 8%.
To top it all off, most income investments have enjoyed a huge
bounce in the stock and bond markets this year. In short,
chasing yield in this environment is a risky game and it's
likely to end in an accident.
Earlier this year, I introduced my subscribers to a new strategy
for collecting income. This strategy is called "covered call
writing" and it makes use of the options market to generate cash
income.
Covered call income is unique in the world of finance. It's the
only way I know to earn a high yield, without taking a flyer on
some issuer's ability to pay you back. With all the risk in the
credit markets right now, earning income this way is an
incredibly useful strategy.
So how does it work?
Essentially, you sell the future upside in a stock position you
own to another investor in return for a cash payment today. It's
incredibly simple...
There are two parts to a covered call trade. First, you buy a
stock. Then, you sell a call option against that stock. You
receive a premium for selling the call option. In return, you
promise to sell your stock if it rises past a certain price in
the future.
Last year, we earned income this way from blue-chip stocks.
Volatility peaked in November 2008, when the credit markets were
broken and the future was uncertain. The S&P 500 had fallen over
-50% at that point. It was the perfect time to use the covered
call strategy. We were able to sell the most expensive options
in history and protect our downside with stocks at decade lows.
We made more than +40% on safe stocks like Coca-Cola and Intel
in one year.
The problem is, covered call writing on blue-chip stocks is not
a slam dunk like it was months ago. Option prices are down -78%
from their peak in 2008, seriously hurting our potential income
stream. Meanwhile, the stock market has rallied +70% in nine
months. Signs of weakness are starting to appear. Former market
leader Goldman Sachs just hit a two and a half month low. As my
colleague Brian Hunt has shown, there is no buying power behind
market rallies any more.
If you think stocks are set for a period of profit-taking
weakness like I do, here's a unique covered call strategy to
consider: Writing covered call options on "inverse"
exchange-traded funds (ETFs).
Inverse ETFs are investment funds set up to move in the opposite
direction of conventional stocks and ETFs. Take the Inverse
China ETF (NYSE: FXP) for example. It is structured to
return double the inverse of the major China ETF (NYSE: FXI).
Or the Inverse Financial ETF (NYSE: SKF). It is set up to
return double the inverse of a bank stock index. (Due to the
imperfect way they are set up, these funds don't perfectly
mirror regular returns. But over the short term, they get
close.)
SKF falls when the bank stocks rise. It rises when bank stocks
fall. Right now, SKF is cheap, having fallen from more than $200
a share to $24. Meanwhile, there's plenty of volatility in the
stock price. Right now, SKF trades for $24.50. You can buy a
batch of shares and sell January $26 call options on the
position for $1.41. That's a 5.7% instant payment on your ETF...
for just two months. And you get to keep a little bit of upside.
Selling covered calls on SKF makes money as long as bank stocks
don't soar and send SKF down in value. It makes money if bank
stocks trade sideways or decline a bit.
I don't recommend this sort of "income trading" to most
investors. It requires a good sense of timing. It requires you
to be handy with options. But conventional income investing just
isn't paying off right now. If you're comfortable with doing a
little extra work, consider the strategy above.
-- Tom Dyson
Contributing Editor
Daily
Wealth
Editor's Note: This
article originally appeared in
Daily Wealth. |
